Two Great Depressions

Beliefs and arguments concerning the Great Depression reappear every time things get bad enough to raise the question of how to make sure we don’t have another. One account I have repeatedly encountered goes roughly as follows:

After the stock market crash, Hoover cut taxes and government expenditure in order to revive the economy. Instead of reviving, things got worse and worse until Roosevelt came in, introduced the New Deal, and so eventually ended the Depression.¹

The obvious conclusion is that we should deal with present problems by vastly expanding government expenditure.

The first half of this is a simple factual claim, easily checked. The current Statistical Abstract of the United States is conveniently webbed but does not go back far enough to provide figures for expenditure under Hoover but earlier volumes of the Statistical Abstract are also webbed. The 1935 volume contains figures both for federal expenditure and for prices in the relevant years. Federal expenditure was:

1929 3,298,859
1930 3,440,269
1931 3,779,868
1932 4,861,696
Far from being cut, it increased every year.

These figures understate the increase because prices and national income were falling. Measured in purchasing power rather than in dollars, federal expenditure roughly doubled over the final three years of Hoover's administration. Relative to GDP, it nearly tripled.

The second half of the story is trickier, because it depends on assumptions about what would have happened without the New Deal — that the Depression would have continued forever, or at least for much longer. That seems implausible, judging by other depressions and recessions; the Great Depression was unusually long, not unusually short. Arguing that since the economy eventually recovered the New Deal was a success is like arguing that if the doctor bleeds the patient and the patient eventually recovers, the treatment was a success.

We can learn a little more by looking at a different Great Depression. From 1920 to 1921 the consumer price index fell by 10.8%, more than in any year of the Great Depression; it fell another 2.3% in the next year. Unemployment rose to about its 1931 level. Looking at that data, it was obviously the start of a depression. Harding did what Hoover is supposed to have done:

1920 6,141,745
1921 4,468,713
1922 3,195,685
1923 3,244,690
1924 2,946,401

By 1923 the recession was over. It was the Great Depression that didn't happen.

The Living Dead: Thoughts on Macro and Depressions

One of the reasons I have never become seriously involved in macroeconomics is that it lacks a theoretical structure as solid or as well supported as price theory, popularly but misleadingly labelled "Microeconomics."² A course in macro is, as I like to put it, a tour of either a cemetery or a construction site.

The cemetery is the orthodox Keynesian account according to which a depression is the result of insufficient demand due to the exhaustion of investment opportunities, monetary policy is useless because the economy is in a liquidity trap, and the proper solution is for the government to run a large deficit, converting excess savings into government expenditure. That was the accepted wisdom fifty years ago. As best I can judge, as observer not participant, it fell out of favor among academic economists in the ensuing decades due to both theoretical and empirical problems.

The construction site is the attempt to replace the old orthodoxy; some of it gets labeled "monetarism," some "neo-keynesianism," some other things. None has been sufficiently successful to have become a new orthodoxy. That is one reason why the old orthodoxy maintained its popularity in popular culture, including that of politicians and journalists; it takes a candidate to beat a candidate.

A second reason why the old orthodoxy survives is that it provides a justification for large scale deficit financing, something politicians, left and right, are fond of whenever they have a plausible excuse. It reappeared under Obama in full force, complete with the claim to be what everyone who knows anything about the subject believes,³ and was used to justify deficit spending on a scale large even compared to that of the previous administration.

Think of it as the rise of the living dead.

All of which leaves open the questions of why things went wrong in the Great Depression and the more recent Great Recession and what should be done to fix them. I do not have a confident answer to those questions but there is one possible answer which I find at least plausible. It is an explanation not of why a depression or recession starts — that, in the two cases of interest, seems to depend on special circumstances — but of why it is so severe and lasts so long.

The Great Depression of the thirties and the current Great Recession have one feature in common that has not, I think, received sufficient attention — the government response to them. Hoover reacted to the 1929 stock market crash by sharply increasing federal expenditure. FDR went on to enormously expand the role of government in the economy, creating our modern regulatory state. Obama followed a similar policy on a smaller scale, expanding government involvement (already very large) in the health care and financial industries, bailing out failing firms on a scale I think unparalleled in U.S. history, threatening additional large scale interventions to deal with global warming.

The result, in each case, was to greatly increase the uncertainty of the environment within which private actors were making their decisions. If you do not know what the future is going to be like, there is much to be said for postponing any decision that depends on the future, whether an investment in physical capital or human capital. It is risky to hire new employees if you do not know whether, a few years hence, it will be legal to fire them. It is risky to build a new factory, in any industry where energy is a major cost, if you do not know whether next year's legislation will sharply raise the cost of energy, better to wait to choose your design until you have a clearer idea of what your costs are going to be. It is risky to choose a profession or change professions when you do not know whether the growth field is going to be health care or bankruptcy law. Multiply such considerations many fold and you may have an explanation of why the recovery from the initial shock, which required individuals to adjust what they were doing to new circumstances, was in both cases so slow.

Arguably the U.S. economy is suffering from a disease in part iatrogenic. Which may explain why the doctor can't understand what went wrong.⁴

1. For example, David Frum at the 2010 CPAC:

“Threatened with the exhaustion of its gold supply, the government felt it had no choice: It had to close the budget deficit. So, in the throes of a severe downturn, the U.S. government did exactly the opposite of what economists would otherwise advise: It cut spending and raised taxes - capsizing the economy even deeper into depression.”

Nicholas Kristoff in a 2011 column:

"If Senator Rubio believes that the response to a weak economy is to slash spending, he is embracing the approach that Herbert Hoover discredited 80 years ago."

2. Consider that the economics of the world wheat market is a problem in microeconomics.

3. “In early 2009, I recall President Obama as having said that while there was ample disagreement among economists about the appropriate monetary policy and regulatory responses to the financial crisis, there was widespread agreement in favor of a big fiscal stimulus among the vast majority of informed economists. His advisers surely knew that was not an accurate description of the full range of professional opinion.” (Thomas Sargent, winner of the 2011 Nobel Prize in economics for his work in macro, interview)

4. A commenter points me at an article by Robert Higgs arguing my thesis for the Great Depression in much more detail: Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War.